This year is getting underway with the alternative fund industry facing a series of changes and challenges in its operating and regulatory environment, from new European Union legislation to the fund sector's role in the global climate transition and the shift in individual investment preferences toward alternative strategies.
Luxembourg has entered 2024 as a key domicile and servicing centre for the cross-border alternative investment industry in Europe, with its readiness to embrace new regulatory developments and the unrivalled expertise of its service provider ecosystem having propelled the assets of regulated alternative funds up to almost €1trn.
However, a variety of potentially problematic factors surround the industry and the financial sector as a whole, including geopolitical turbulence and actual or potential conflict in various areas of the world, along with attendant economic and financial effects. This on top of the ongoing impact of higher inflation and the sharp rise in interest rates experienced in 2022 and 2023. Meanwhile, private debt is gaining weight among the industry's asset classes as providers step into a gap left by banks' retreat.
Infrastructure is also gaining a higher profile as a cornerstone of the sustainability transition, which will require the deployment of trillions of euros in private capital over the coming decades if European and national decarbonisation targets are to be met.
Regulatory uncertainty over sustainable investment
Sustainable investment remains a critical element of alternative strategies as well as retail funds, even though the past two years have seen performance dip by comparison with traditional funds, notably because of the surge in energy prices following Russia's invasion of Ukraine. Inflows have also been affected by lacklustre returns and, in the US, the unwelcome targeting of ESG investment and net zero ambitions in politically-driven culture wars.
That's less of a problem in Europe, which currently accounts for around 45% of global assets in sustainability-focused funds. In addition, surveys of institutional, professional and high net worth investors give no indication of any backsliding among the core investor groups for alternative funds.
More regulatory changes are on the way, with the start of reporting under the Corporate Sustainability Reporting Directive next year promising to help asset managers and their service providers obtain more easily the data they need to comply with the Sustainable Financial Disclosure Regulation.
However, the SFDR has itself become a source of uncertainty, with the European Commission acknowledging that the use of articles 8 and 9 as de facto fund labels and persistent lack of clarity about what 'sustainable investment' entails might mean changes are required to make different categories of fund more comprehensible to investors. The UK's planned approach - involving labels covering investments in improvers in transition, impact funds and funds that hold sustainable assets - is one possible model under consideration.
What future for Due Diligence and Unshell directives?
Many asset managers and service providers may welcome the current legislative impasse over the EU's Corporate Sustainability Due Diligence Directive, which would require companies to address environmental, human rights and other social issues in their supply chain. Luxembourg has been a firm opponent of any requirement for asset managers to examine the supply chain of every company in their portfolios; other member states including France would exclude the whole financial sector. For now, even a compromise text agreed by the EU Council last December that would (at least temporarily) exempt financial institutions lacks a majority to proceed further.
Also stuck in the weeds is the EU's third Anti-Tax Avoidance Directive, dubbed Unshell because of its proposed measures to crack down on use of shell companies to obtain tax benefits. The legislation is a matter of importance for Luxembourg because of the use of holding companies and other entities that have no staff, offices and or material activities within legitimate corporate ownership and investment structures. ATAD III was due to be agreed in 2022 and come into force this year, but at present there appears no prospect of a consensus between EU countries to move it forward.
The long-awaited revision of the European Long-Term Investment Fund Regulation took effect in January, but the expected rush of new products to market has been held up by a delay in approving the legislation's level 2 regulatory technical standards, amid ongoing disagreement between member states about redemption conditions. The ELTIF 2.0 regime, as it has been dubbed, brings new opportunities, but also new complications, in fully opening the door to non-professional investors anxious to gain access to the higher returns available from strategies including private debt, infrastructure and private equity.
However, the reduced liquidity they tend to offer makes the much-heralded switch toward retailisation or democratisation of investment in private assets a delicate balancing strategy for asset managers and their service providers. With ELTIFs and other types of fund, administrators will need to adjust to ensure the scalability of data distribution and other types of communications to respond to the prospect of much larger investor numbers, diversity of the geographical spread, and increased use of digital access channels.
The industry is also set to be affected by other trends over the course of 2024, particularly with regard to financial conditions. Private asset managers are looking forward to the European Central Bank and its counterparts elsewhere starting the process of lowering interest rates, which should help to spur growth in inflows and transaction volumes.
Implications of AI in asset servicing
Businesses will also increasingly need to respond to the growing impact of artificial intelligence on the asset servicing industry. The technology seems certain to have a disruptive impact on employment and workflows, although experts believe it is as likely to change, and even enhance, jobs as to eliminate them. AI can play an important role in improving the efficiency of administrative processes, including the ongoing trend toward offshoring, and in researching and refining investment strategy, but the need for human skills and judgement will remain.
Luxembourg has been the biggest beneficiary of the EU's AIFM Directive over the past decade, but its businesses should not be complacent about bids by other jurisdictions to develop their own competing asset servicing frameworks and ecosystems. An example is the UK's Qualifying Asset Holding Company regime, introduced in 2022 in a bid to attract investment fund holding structures away from Luxembourg or Ireland. While Luxembourg continues to enjoy major advantages over the new rivals, there's no doubt that the market environment is set to become more complicated, and to meet these challenges L3A is examining how it can help keep its members educated and up to speed on these developments.
Meanwhile, the rebound in 2023 in the market price of bitcoin and other crypto-currencies is likely to bring a revival in crypto funds as an alternative asset class, as was seen in 2021. Other drivers of this trend include the EU's Markets in Crypto-Assets Regulation, which will take effect in June (for provisions regarding stablecoins) and December this year, as well as the decision by the US Securities and Exchange Commission in January to authorise spot bitcoin exchange-traded funds for the first time.
Despite the extreme price volatility of digital assets, the trend appears here to stay, especially since analysts predict a further surge in value for the crypto market in 2024; increased use of stablecoins, at least as a means of transferring value between crypto and fiat currency ecosystems, is also likely. However, for the fund servicing industry an even more important development may be the opportunity offered by distributed ledger - blockchain - and tokenisation technology to streamline and fully digitalise its operations.
In a still uncertain economic environment, clouded by geopolitical threats to stability, Luxembourg's asset servicing industry faces challenges aplenty to keep it busy in the months ahead. L3A's members are well positioned to successfully manage these challenges and excited by the wealth of new opportunity that Luxembourg has to offer as it continues to strengthen its leading position in the global alternative fund administration market.